Is “Tantrum” Risk Rising Behind The Scenes?

We’ve said time and again that investors would do well to remember what risk parity knows all too well. Namely that you really, really need a negative stock-bond return correlation when vol spikes and there’s blood in the water in one asset class or the other.

Why? Simple: if everything’s moving in the same direction, there’s no buffer in a drawdown.

Remember, there was a moment last September where it looked like this was in jeopardy. As Deutsche Bank put it at the time:

A ‘policy error’ rate hike might well result in positive correlations among equities, commodities and bonds, due to a combination of risk off and higher rates. In this case it is not entirely clear how risk-parity funds would rebalance

Then, when Trump was elected, optimism around the reflation narrative caused stocks to rally hard while bonds sold off sharply. That is, the stock-bond return correlation moved sharply negative.

Well, note that after last Wednesday’s Fed hike, stocks rallied hard into the close and so did bonds. That’s a positive return correlation. Which is all fine and good as long as things are moving in the “right” direction. But if the likes of Goldman are right – that is, if the Fed didn’t like what it saw in terms of the loosening of financial conditions that followed the hike (i.e. higher stocks and a weaker greenback) and is thus inclined to double down on the hawkish rhetoric – and/or if we get some kind of catalyst that causes the market to reprice yields sharply higher, that positive correlation is going to come back and bite the market in the ass. And we already know that past 3% on 10s, this correlation is almost certain to flip positive.

So consider that with the following chart and draw your own conclusions about “tantrum” risk…

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice